We have long been admirers of the investment skills and thoughtfulness of Howard Marks, co-founder of Oaktree Capital Management. Like Warren Buffett’s Annual Shareholder Letters for Berkshire Hathaway, Mr. Marks’s periodic Memos, which now date back almost three decades, are always worth reading for their thoroughness, and intellectual diversity and depth.
Anyone who wishes to understand what the nature of risk is would be well advised to read a Memo from 2015- Risk Revisited Again in which Mr. Marks (as one should) updates and describes not only what he considers to be the true nature of risk, but provides a useful starting checklist for those risks which one should consider in an investment and business environment.
So, what exactly is risk? As the Memo points out, it should not be confused with volatility (which is a tendency that is still prevalent.) Academics and model-builders like to use volatility because it is a property that can be recorded and measured- just think of Value at Risk (VaR) and the use of such concepts as standard deviations. However, volatility is a fluctuation and is simply a property of most exposures or investments. Risk is something else. As Mr. Marks points out, what investors and risk managers are really concerned with is the possibility of permanent loss. Of course, volatility can expose one to that risk if one is unable to manage it and absorb it, which is why lack of liquidity is such a killer of companies and of investors’ hopes and expectations.
The problem with this is that (to quote the Memo): “The probability of loss is no more measurable than the probability of rain” (which reminds us of Andre Brink’s novel “Rumours of Rain”). Like volatility, one can model it and estimate it, but it can never be fully known ex ante- nor even ex post. After all, just because there was no permanent loss, does not mean that there was no risk. Too often people confuse dumb luck with skill when it comes to identifying, assessing and managing risk.
The Memo wryly quotes JK Galbraith: “We have two classes of forecasters: Those who know- and those who don’t know they don’t know”. Being in the latter category, is never a good idea. Ignorance is not bliss. In the real world, it is far better to recognize that, because the future is unknowable, one can never be certain of how much risk truly exists in a particular investment or exposure, or as a consequence of one’s decisions. Humility is an essential virtue for any risk manager! Far too many things that should not or “cannot” happen actually do. Therefore, one must focus on trying to ensure that the worst possible outcome (the real risk) is not such as to also cause ruin.
In reality, the future is always a range of possibilities. One can try to identity scenarios and assign probabilities to create a distribution, but in the end only one thing will happen (putting to one side the fascinating topic of quantum mechanics!) The probability of that causing a permanent loss may be remote, but the risk will always be there until such time as an obligation has expired. Of course, the entire concept of an “insurable risk” depends upon there being an expected minimum level of risk and thus of loss.
At Awbury, we aim to be assiduous students of risk both as a concept and as an inevitable factor in all that we do. Our business model and franchise depend upon never being self-satisfied or complacent about its existence, nor believing that we must be right. A healthy skepticism and paranoia are also essential virtues for the Team.
The Awbury Team